You must have heard mortgage rates hit a new low. A 15-year fixed rate mortgage and a 30-year fixed rate mortgage are probably the two most popular choices.
You must also know the tradeoffs between a 15-year and a 30-year mortgage. A 15-year loan has a higher required monthly payment, but it pays off faster, because your higher monthly payment goes to reduce the principal. A lower principal together with a lower rate means more of your next payment goes to reduce the principal. The cycle goes on and on. Over the life of the loan, you pay a lot less interest on a 15-year fixed mortgage.
Some like paying less interest but they are not sure if they can commit to the higher monthly payments. They worry if they run into some cash crunch, say one spouse in a couple loses his or her job, they won’t be able to keep up with the payment and as a result they could lose the house.
In that case some then suggest that they should take out a 30-year mortgage but pay it on a 15-year schedule. This means paying extra toward principal in normal times but falling back on the lower required monthly payments if necessary.
Is this a good plan? Yes from a cash flow point of view because it gives you flexibility. No from a cost point of view because the flexibility is not free. It’s not free because a 15-year mortgage carries a lower rate than a 30-year mortgage.
I call the cost of doing this "payment flexibility insurance" because that’s really what it is. You pay a premium for the off chance that you will need the flexibility.
How much does it cost to take out a 30-year mortgage but pay it on a 15-year schedule versus taking out a 15-year mortgage outright? It of course depends on the loan amount. The higher the loan amount, the higher the cost.
I give some examples using rate quotes from an online lender.
Example 1. Nancy refinances a $200k loan in Missouri. She can get a 30-year fixed rate mortgage at 3.75% or she can get a 15-year fixed rate mortgage at 3.125% at comparable closing costs. To pay off the 30-year loan in 15 years at 3.75%, Nancy will have to pay $1,454 per month instead of the required $926 per month. To pay off the 15-year loan at 3.125%, the required monthly payment is $1,393. The cost of payment flexibility insurance is $1,454 – $1,393 = $61/month or $735 per year for 15 years.
|Monthly payment on a 15-year schedule||$1,454||$1,393||$61/month|
Example 2. Bob refinances a $400k loan in California. He can get a 30-year fixed rate mortgage at 3.5% or he can get a 15-year fixed rate mortgage at 2.875% at comparable closing costs. To pay off the 30-year loan in 15 years at 3.5%, Bob will have to pay $2,860 per month instead of the required $1,796 per month. To pay off the 15-year loan at 2.875%, the required monthly payment is $2,738. The cost of payment flexibility insurance is $2,860 – $2,738 = $121/month or $1,454 per year for 15 years.
|Monthly payment on a 15-year schedule||$2,860||$2,738||$121/month|
How does the cost of payment flexibility insurance compare to the cost of other insurance? Maybe $735 a year isn’t too bad but at a higher loan amount, the cost is really high. $1,454 a year is more than the premium for insuring my two cars with collision, comprehensive, and the highest liability coverage. It’s also more than my homeowner’s insurance premium.
With auto and homeowner’s insurance, you are insuring against some big losses: a serious accident causing injury to others, your home burning down, etc. What do you get from payment flexibility insurance? Just relief from a temporary cash crunch.
I don’t think the cost is worth it. There are other better ways to deal with a temporary cash crunch. Beef up your investments and emergency fund. Be willing to cut back on other expenses if a temporary cash crunch develops.
You see if you make a commitment to making the higher monthly payments with a 15-year mortgage and not be wishy-washy about it, you get to save a lot of money.
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